Sterling Strength and 'Real' Differentials

The British pound is the best performing currency so far this quarter (+2.0%
vs USD) as well as over the last 6 months (+5.7% vs USD) out of the top-traded
11 currencies.

Real differentials in 2-year govt bond yields (yield minus inflation)
have helped explain currency performance over the last 2 years, including
sterling's strength since last autumn.

Such yield superiority is underscored by higher gilt yields and moderate
inflation.

Currency performance is best measured against gold to highlight common denominator.
Chart shows gold has fallen the most against GBP, -19% since May 6, 2013.

The simultaneous decline in UK inflation and unemployment rates, as well
as the increase in real wages (earnings minus CPI) reflect the importance
of GBP strength in maintaining inflation expectations anchored within
the BoE's target at a time when further tightening in labour markets emerged
alongside the slow but gradual expansion in UK growth.

Despite US 2-year yields exceeding their German counterparts by 0.27%, they're
not sufficiently priced to account for the higher inflation differential with
the Eurozone, considering Eurozone CPI at 0.7% y/y and US core PCE at 1.2%.
This helps explains EUR outperformance of US.

The index of economic surprises in the UK continues to exceed that of the
US, Japan, Germany, Canada and China. Wage growth is closing the gap with inflation
and business surveys have remained robust after hitting multi-month highs earlier
this year. Not only these figures (including positive real wage growth) will
favour PM Cameron's re-election bid next year in showing the positive spillover
from the City onto main street, but they will translate into an added boost
to finally see a break above $1.69 in GBPUSD.

For these reasons, we continue to expect NO verbal intervention from the Bank
of England regarding sterling strength. If anything, the market will likely
keep on buying sterling on the dips based on the classic combination of
improved growth-low inflation. $1.7130 is now our objective and any decline
below $1.66 is behind us for now.